Volatility skew refers to the actual difference in IV or Implied Volatility, between ‘out of the money’, ‘in the money’, and ‘at the money’ options. Volatility skew is extremely important for fund managers for writing calls and puts. In other terms, it is also called the vertical knew. It is affected largely by the relationship between supply and demand, and also by sentiment.
In a situation, when ‘out of the money’ options have higher IV than ‘at the money’ options, it is called the volatility smile. Basically, the shape on the chart looks more like a “U” or looks like a smile. A skew occurs in the equity markets mainly because fund managers prefer to write calls over puts. In general, the volatility skew is presented in a graphical way to demonstrate the Implied Volatility of different options. Typically, the options used for the purpose have the same ‘strike price’ and expiration date, although it is possible that the options may have different dates.
Volatility refers to the level of risk. It is directly related to the asset that’s associated with the option. Volatility is derived from the price of the option. Please note that it is possible to measure or analyze the IV directly. In more simple terms, as the price of the underlying asset goes down, the IV goes up.
What’s the strike price?
The strike price is the actual price at which the option may be ‘exercised’. If the contract is exercised by the buyer, he may just buy the associated asset. Or else, the put option buyer may sell the associated asset. The difference between the strike price and spot price determines the profits eventually. For calls, the profit is calculated by the actual amount by which the spot price increases or exceeds the relevant strike price, while the case is just opposite for puts.
What’s Reverse skews?
If the IV is higher on lower option strikes, it is a case of Reverse skews. Reverse skews are mainly seen with index options. On the contrary, investors may also come across Forward skew, which is mostly seen in the commodities market, where supplies issues can hike the price. For items related to agriculture, forward skews are known occur.
It is not hard to Volatility skew. You can look at the IV data of the concerned chain. Check online now to know more on this topic.
Author Bio: Kim Klaiman is an author on finance and money. She is also a guest writer for many blogs and likes to work in the options market as a trader out of passion.